Charting A Ridiculously Extreme Market, In Which The Dumb Money Is The Most Confident It Has Been In 5 Years

One of the sad side-effects of taking away investment risk, as Ben Bernanke has done with his "global put" doctrine, is that the old maxim of the market staying irrational far longer than anyone can possible imagine, can now be exponented to some irrational infinite number (to throw some wacky number theory into the equation). Whether Bernanke can also succeed in defying nature and mathematics in broad terms remains to be seen: we have yet to see a system that can diverge from equilibrium in perpetuity without some very unfortunate unanticipated side-effects somewhere. Yet with the bulk of day-trading systems now primed to do nothing but chase momentum, this divergence could lead to unseen previously deviations. We are confident that while printing a reserve currency (whose reserve status is rapidly diminishing) is one prerogative that Ben has, changing the laws of thermodynamics is one field where Bernanke will fail. Nonetheless, in its attempt to destroy all bears, only to be followed by the annihilation of all bulls (as the TBTFs pocket all the margins, and capital gains) the market continues to be nothing less than a casino primed with far greater house odds than even the worst slot machines in Atlatnic City. And just like in AC, accrued profits are not real, until taken. And if taken one second too late, they merely become deferred losses. That said, we would like to present some very factual representations to just what extreme level the market has been overbought in this latest year end push to make hedge fund managers richer (who are the only ones who get to be paid at year end without booking profits, of course assuming they beat the S&P, which means about 33% of them). Courtesy of www.sentimentrader.com we can observe just how irrational the market has become... As to how much longer it can sustain this, feel free to address your questions to the Chairman.

First, we present the confidence of smart and dumb money. Never before has it been as self-gratifying for "dumb money" advocates (i.e., those who do nothing but "trade the tape") to exude a sense of complacent all-knowingness. After all, they will always be able to sell just ahead of the wipe out...

For those confused by what the distinction is, here is sentiment trader's explanation:

Generally, we want to follow the Smart Money traders – we want to bet on a market rally when they are confident of rising prices, and we want to be short (or in cash) when they are expecting a market decline. We also call this measure the "Buy Confidence" indicator - it tells us how much confidence we should have in buying the market.

Examples of some Smart Money indicators include the OEX put/call and open interest ratios, commercial hedger positions in the equity index futures, and the current relationship between stocks and bonds.

In contrast to the Smart Money, we want to do the opposite of what the Dumb Money is doing. These traders have proven themselves over history to be terrible at market timing. They get very bullish after a market rally, and bearish after a market fall. By the time the majority of them catch on to a trend, it’s too late – the trend is about to reverse. That's why we call this the "Sell Confidence" indicator too, as it tells us how confident we should be in selling the market.

Examples of some Dumb Money indicators include the equity-only put/call ratio, the flow into and out of the Rydex series of index mutual funds, and small speculators in equity index futures contracts.

Our Confidence indices are presented on a scale of 0% to 100%. When the Smart Money Confidence is at 100%, it means that those most correct on market direction are 100% confident of a rising market…and we want to be right alongside them. When it is at 0%, it means that these good market timers are 0% confident in a rally, and we want to be in cash or even short when confidence is very low.

We can use the Dumb Money Confidence in a similar, but opposite, manner. For example, if the Dumb Money Confidence is at 100%, then that means that these bad market timers are supremely confident in a market rally. And history suggests that when these traders are confident, we should be very, very worried that the market is about to decline. When the Dumb Money Confidence is at 0%, then from a contrary perspective we should be concentrating on the long side, expecting these traders to be wrong again and the market to rally.

In practice, our Confidence Indexes rarely get below 30% or above 70%. Usually, they stay between 40% and 60%. When they move outside of those bands, it’s time to pay attention!

Little to be added there.

Next up we look at the Options Speculation index, which, not surprisingly, is far beyond the highest it has been in the past 5 years, possibly ever.

While it is rather self-explanatory, here is the official interpretation of the chart:

The Options Speculation Index takes data from all the U.S. options exchanges and looks at opening transactions.

We total the number of transactions with a bullish bias (call buying and put selling) and also the number of those with a bearish bias (put buying and call selling).

The Index is a ratio of the total bullish transactions to the total bearish transactions.

The red and green bands on the chart are 2 standard deviations from the one-year average of the index.

Like most other put/call ratios, this is a contrary indicator, so when we see excessive speculative activity (i.e. the indicator moves outside of the upper red trading band), it means that traders are very confident of a rising market, and we usually see just the opposite.

When we see too much risk-aversion and the indicator moves below the lower green trading band, then we're at a pessimistic extreme and we typically see a market rebound shortly thereafter.

Next, we look at the Large Only, Buy to Open (L.O.B.O.) Put/Call Ratio:

This one is a little trickier, although as can be seen it too is at (at least) a five year high:

The LOBO ratio is made up of only large traders, those trading 50 or more contracts at a time. Granted, with low-priced options, even a small trader could fit into this category, but for the most part these reflect institutional-type traders.

Because of that, there is an added complexity to the interpretation of this ratio. The ROBO ratio is pretty clear - when small traders are buying puts, then they're bearish on the market; when they are buying calls, then they're bullish.

With large traders, they could be buying puts not only to speculate on a decline, but more likely as a hedge against their existing positions. So when we see a large rise in put buying, it could actually mean that these traders are so bullish that they have bought a large amount of stock, and need to hedge against that. And when they're buying a large amount of calls, it could mean that they have sold or shorted stock and need a hedge against a runaway upside market.

So the underlying reasons for high or low put/call ratios differ from the ROBO ratio, but fortunately when we look at the chart it doesn't make much of a difference.

On the chart, we show three indicators - the LOBO Put/Call Ratio, the percentage of total large-trader volume that went into buying call options, and the total large-trader volume that went into buying put options.

The guidelines are straightforward. When any of the ratios move outside of the upper red dotted line, then we should look for the market to decline; when any move below the lower green dotted line, then we should look for the market to rally.

The euphoria is just as visible in the ISE Sentiment index:

The summary:

The International Securities Exchange (ISE) is an all-electronic options exchange. It has been steadily gaining market share since its relatively recent formation, and in 2005 it often traded more options contracts than any other exchange, including the Chicago Board Options Exchange.

In its capacity as a leading options exchange, the ISE has a wealth of information at its fingertips. In 2002, it unveiled a sentiment index based on the volume traded there. As a potential improvement to the put/call data provided by the CBOE, the ISE created its index using only those options that are bought to open. This gives us a more "true" feel for the sentiment behind the options trades, as the data is not skewed by large institutional options sellers.

The interpretation of the ISE Sentiment Index is very straightforward. When it is high, it shows that customers have been buying a lot of calls options in relation to put options. That means that they are likely making heavy bets that the market will rise. Conversely, when the Index is low, it means that traders are buying relatively few calls compared to puts - a sign of pessimism.

Like all other contrary indicators, we want to look for higher market prices when pessimism is very high (coinciding with a low Index reading) and look for lower market prices when traders are very optimistic (i.e. when the Index is high).As noted above, we should expect a market decline when traders are very optimistic. Therefore, when the ISE Sentiment Index shows a daily reading of 250 or above (meaning traders are buying 250 calls for every 100 puts), or the 10-day moving average is 200 or higher, we should be cautious.

We are at 230.

And lastly, it is fair to point out that not everyone is betting on an infinite market increase. CFTC COT disclosed commercial Nasdaq 100 hedgers continue to be near their year's net shortest, even as the "coincident" small specs has rarely seen a more euphoric market: after all the Nasdaq is at December 2007 levels: what can possibly go wrong.

Another largely self-explanatory chart:

Commercial Hedgers - Commonly believed to be the "smart money", these traders are involved in the day-to-day operations of each commodity. They have an excellent handle on the underlying market, and it typically pays to follow their positions when they reach an extreme.

Large Speculators - This group mostly consists of large hedge funds, and almost always take the opposite side of commercial traders. The are primarily trend-followers, and will accumulate positions as a trend progresses. When their positions reach an extreme, watch for a price reversal in the opposite direction of the existing trend.

Small Speculators - These are smaller traders, composed mostly of hedge funds and individual traders. Again, they are mostly trend-following in nature and we often see price reversals (in the opposite direction) when they hit an extreme.

To make the chart quicker to read, we invert the indicator values on the chart, so that the equivalent of an "overbought" reading is at the top of the chart, and the equivalent of "oversold" is near the bottom.

When Commercials become net long to an extreme degree (i.e. below the green dotted band), then we should be looking for the index to rise. The opposite is true when they become so hedged that their position goes above the red dotted band. These commercial traders have been especially active and useful in the Nasdaq 100 futures over the past several years.

You also want to look at the absolute level of positions, too - if they're at their greatest extreme in several years (even if they may not exceed the trading bands), then there's no question we're seeing a notable event.

As always, we merely bring you the facts. If readers wish to go against the grain of the broader public which has now decided to end its affair with stocks (at least for the time being, as demonstrated by 31 consecutive outflows, and not even closely matched by ETF inflows, a fallacy we debunked some time ago), and join the "dumb party's" money, no matter how short- or long-lived it may prove to be, they are now aware what the market reality is. And hopefully, they will also realize that a 50% rise in notional stock prices coupled with a 50% drop in purchasing power ends up being a loss any way it is perceived. But then again, they are called "dumb money" for a reason...